The S-Corp payroll tax issue is back in play! This issue was debated two years ago in the Senate and it went nowhere then but, according to the news sources today, the Obama Administration and Senate Democrats are planning to bring up the issue again in order to raise taxes on S corporation shareholders by $6 billion to offset the cost of extending low interest rates for student loans.

Though decisions have not been finalized, it seems at this time that the proposal would affect S corporation with earnings of at least $250,000 annually and it would be targeted to raise roughly $5 billion to $6 billion over the coming decade.

The Democratic plan would tighten the definition of S corporation income on which payroll taxes must be paid. The
bill will require S Corporations with three or fewer shareholders who declare income of at least $250,000 a year to pay employment taxes.

An S Corporation is a corporation whose shareholders have made a special election to be taxed as partnerships instead of being taxed as a corporation. That election means that the tax-attributes of the corporation are passed through the corporation with little or no tax and reported on the shareholders’ individual income tax returns instead. The rub, if you , will, is that presently the income that passes through the S corporation to its shareholders is not considered earned income and so it is not subject to Social Security or Medicare taxes.

This specific area has been a point of contention between S corporation shareholders and the Internal Revenue Service for decades. The problem, as the IRS sees it, is that shareholders sometimes pay themselves unrealistically low wages in order to avoid the Social Security and Medicare taxes. Instead the businesses report a high net income which is passed through to the individual return with no corporation level tax and is not subject to the Social Security or Medicare taxes at either the corporation on the individual tax return levels.

Today there is a body of legal decisions supporting the IRS position that when the shareholder’s salary is unrealistically low the distributions that are made to the shareholder may be partially or fully recategorized as wages and Social Security and Medicare taxes paid at the corporation level as a result or the recategorization.

So the question today is do we need new legislation to make shareholders pay their fair share of Social Security and
Medicare taxes?

What do you think?

A local newspaper reported that over the course of less than three years a charter school’s financial manager embezzled about $400,000.  The school operated on an annual budget of about $600,000.  The article made clear that the person who did the stealing was a valuable member of the school’s team.  “She was committed” said the school principal, “she never slacked.”  The article also brought up the fact that the school had an annual financial audit by a CPA firm.  The audit had turned up some small issues but nothing like the embezzlement that seems to have been happening as they worked.  So, how was the theft uncovered?  Police got a tip from the US Department of Treasury’s Financial Crimes Enforcement Network, who suggested that they look at the financial manager’s personal bank accounts.  They did and then contacted the school.

How does someone steal that much in such a short period of time?  “It wasn’t noticed because there was nobody else looking” said the district attorney assigned to this case.  “I think she was very trusted.  Unfortunately it was a misplacement of trust.”

What is the take-away from this story?  The first is that having a financial audit, while very helpful is not a substitute for being smart.  Your business or nonprofit must be actively involved in the oversight process.  Good internal control policies come from the top down, not the other way around.  Another piece of information that we can learn from this story is that you need to pay attention to your employees and how they behave, or change their behavior, over time.  In this case, apparently all of the stolen money was used to buy drugs.  Another take-away from this story is that companies need to do a solid background check before they hire someone, especially someone who is going to be handling their money.  As it turned out in this case, the person who was caught stealing was convicted on a felony drug charge two years ago, while she was working at the school, and had been arrested three times in a six-month period a year before she was hired.

One final note on this story is that this is not an isolated incident but is one that occurs over and over again as businesses and nonprofit organizations fail to realize that people, even trusted members of the “team”, have and will fail and you need to be aware all of the time.

I will put up on my web site a laundry list of employee behaviors which may indicate that the employee is having some problems.  Problems are one thing and we can all go through those ups and downs, but you still need to protect your assets while being concerned for an employee’s welfare.

Be smart, think.